A striking
development of the last decade has been the rise in reserve holdings among
developing nations. The rise in the ratio of reserve holdings to GDP has
occurred in every region of the world, and has been especially rapid in the
years since the East Asian financial crisis. As a result, some countries, such
as Taiwan and Malaysia, now hold an amount of reserves that exceeds 30 percent
of their GDP.

Reserve holdings carry a considerable cost. A dollar held as reserves is
essentially a dollar of foregone investment for a developing nation. If these
nations had not increased their reserve holdings, they could have used this
money to support investment in physical or human capital. The cost of the
build-up of reserves is then the difference between the return on investment in
developing nations and the small returns (typically 1-2 percent real returns)
available on the assets held as reserves.

This paper uses World Bank data to document the rise in the ratio of
reserve holdings to GDP. It finds:

there
has been a large rise in the ratio of reserves to GDP in every region from
the 1960’s to the 1990’s, with a further increase following the East
Asian financial crisis.

the
largest increases were in the East Asian region and the Middle East, with
the average reserve holdings rising by more than 10 percentage points of GDP
in each case from the sixties to the nineties, with the East Asian region
experiencing an additional increase of more than 2 percentage points in the
late nineties.

South
Asia, Latin America, and Sub-Saharan Africa all experienced a rise in the
ratio of reserves to GDP of at least 4 percentage points from the sixties to
the nineties, with both Latin America and Sub-Saharan Africa experiencing
increases of close to 8 percentage points using data from the last three
years of the decade.

the
implied cost of this rise in reserve holdings is 0.4-1.0 percent of annual
GDP in South Asia, and between 1.0 and 2.1 percent of annual GDP in East
Asia. The cumulative costs of a decade of reserve holdings at late nineties
levels (compared to the cost of sixties levels of reserve holdings), could
exceed 20 percent of current GDP in East Asia and would be close to 10
percent of current GDP for nations in Sub-Saharan Africa and Latin America.
This would be equivalent to a loss of between 1 and 2 trillion dollars in
the United States.

There is no widely accepted
explanation for the rise in reserve holdings, but it is likely that an increase
in the instability of the world financial system has played a major role. The
data in this paper suggest that the growing instability of the international
financial system has imposed a large cost on developing nations in recent years.
This increase in instability, in spite of the developments in technology and
economic theory, constitutes a serious failure by the architects of the current
financial system.

Introduction

A striking, but little noted, phenomenon of the last four decades has
been the increase in the amount of foreign reserves held by central banks
throughout the world. In every region of the world central banks are holding far
larger reserves, relative to the size of their economy, than they did in the
sixties. In fact, in the developing world, the average ratio of reserve holdings
to GDP has more than doubled between the sixties and the nineties. Some
developing nations, such as Taiwan and Malaysia, now hold an amount of reserves
that exceeds 30 percent of their GDP. A comparable sum in the United States
would be $3 trillion.

This increase in reserve holdings has received remarkably little
attention from economists and policy analysts. The lack of attention is striking
because there are large costs associated with holding reserves. Essentially, the
cost of holding reserves is the investment that these nations must forego in
order to accumulate reserves. In other words, the dollars that developing
nations must hold as reserves are dollars that cannot be spent on health care
and education, on physical infrastructure, or on the promotion of private
investment. By diverting resources from more productive uses, the dramatic rise
in reserve holdings over the last four decades has significantly impeded
economic and social progress in developing nations.

This paper documents the rise in reserve holdings over the last four
decades and provides preliminary estimates of the costs attributable to this
increase. These estimates indicate that the costs are quite large, on the order
of 1.0-2.0 percent of annual GDP for most nations. Taken over the course of a
decade, the cumulative costs could run as high as 15 to 25 percent of GDP. To
put this in context, for the U.S. economy this would mean a cumulative cost over
the course of a decade of between $1.5 and $2.5 trillion, or between
$5,000-$8,000 for every person living in the country.

Before detailing the rise in reserve holdings over the last four decades,
it is worth clarifying the mechanism through which reserve holdings impose costs
on developing nations. This is the topic of the first section. The second
section briefly examines possible explanations for the rise in reserve holdings.
The third section presents the data on reserve holdings from the sixties through
the nineties, and the cost of the increase in the ratio of reserve holdings to
GDP. This is followed by a brief conclusion.

Why Reserve Holdings Are Expensive

The fact that nations now have a much higher ratio of reserve holdings to
GDP would not be of much consequence, if there were no cost to holding reserves.
However, the cost is in fact quite substantial. As Neely (2000) and Ben-Basset
and Gottlieb (1992) have pointed out, the opportunity cost of reserve holdings
is the marginal product of capital in the nation holding the reserves.[1]

This point can be seen by examining the process through which nations
acquire reserves. In order to increase its holdings of reserves, a nation must
manage to run a balance of payments surplus. The net increase in reserve
holdings is the extent to which the total amount a nation receives in foreign
currency– whether from trade,
factor income flows, direct investment, portfolio investment, or aid – exceeds
the total amount it pays out for these purposes.[2]
Put another way, the increase in reserves is equal to the surplus of national
savings over investment, plus the net inflow of foreign investment and aid. A
dollar that is added to reserves is a dollar that could otherwise be spent on
investment.

This can be demonstrated most clearly by taking an extreme case. A nation
could, in principle, contract with a foreign firm to construct a factory or
other facility, with the money it is accumulating as reserves. As a practical
matter, there may always be leakages going from one form of saving (reserves) to
investment, but, in principle, the entire value of a nation's reserves
correspond to savings that could otherwise have been invested in physical or
human capital.

The return on physical capital varies depending on the time period and
the country. The before-tax return in the United States has averaged close to 10
percent over the post-war period (Baker 1996).[3]
The returns in developing nations will generally be considerably higher to
compensate for the greater degree of risk. It is likely that the return to
capital exceeds 20 percent in many of the poorer developing nations. There is
evidence that public investment in infrastructure or education, two other
alternative uses of assets held as reserves, may provide even higher rates of
return than physical capital (e.g. Munnell 1994; Holtz-Eakin and Schwartz 1994).

In calculating the cost of holding reserves, it is important to recognize
that reserves do provide some return. The cost of holding is therefore the
difference between the opportunity cost and the real return on reserves. The
portion of reserves held as interest bearing deposits, or as the short-term
government debt of the United States and other nations that supply reserve
currencies, will typically earn a small positive real rate of interest. In the
post-war period this has averaged between 1.0-2.0 percent. Reserves held as
gold, currency, or in non-interest bearing accounts will provide no real return,
on average. Given the mix of assets held as reserves, the average return can be
assumed to be in this range of 1.0-2.0 percent, although probably closer to 1.0
percent than 2.0 percent.

This analysis presents two sets of estimates of the cost to developing
nations of holding reserves in order to construct a plausible range. The low end
estimate assumes that the cost of holding reserves is 10 percent[4].
This assumption implies that the return to physical or human capital in
developing nation is only slightly higher than in the United States, the
difference being equal to the real return on reserve assets. The high end
estimate assumes that the cost of holding reserves in the developing nations is
20 percent, implying a relatively high rate of return on human or physical
capital. Since the return to capital (both physical and human) will differ
across nations, the actual opportunity cost of holding reserves will vary. It is
reasonable to assume that the opportunity cost in richer developing nations will
be closer to low end of this range, while it will be nearer to the high end of
the range in the poorest nations.

It is also worth noting that the costs to developing nations are benefits
to the nations that supply reserve currencies. When developing nations increase
their holdings of foreign reserves in the form of reserve currencies, they are
effectively providing low interest loans to the nations (primarily the United
States) that supply reserve currencies. This allows the suppliers of reserve
currencies to import goods and services without having to pay for them in the
present.

Explanations for the Rise in Reserve Holdings

There are two main explanations that could be put forward for the rise in
the ratio of reserve holdings to GDP in the last four decades. The first is
simply that trade has increased relative to GDP in most nations, and that it has
been necessary to increase reserve holdings in step with the rise in trade. The
second explanation is that the international monetary system has become more
unstable over the last four decades, therefore it is necessary for developing
nations to hold more money in the form of reserves in order to protect their
economies from this instability. It is likely that both of these factors
contributed to the rise in the ratio of reserve holdings to GDP.

The way in which trade would contribute to an increased need for reserve
holdings is straightforward – reserves are needed to smooth out payment
imbalances – for example if there are delays in receiving payments for
exports, or the inflow of capital is temporarily disrupted for some reason. It
is reasonable to believe that the amount of money needed to deal with these
sorts of imbalances would bear a relationship to the overall flow of trade. When
the ratio of trade to GDP rises, it should be expected that the ratio of
reserves to GDP would rise as well.

While the basic logic of this explanation is quite simple, it is
important to note that the rise in reserves should be less than proportionate to
the rise in trade. There are two reasons why this would be the case. First,
reserves held to maintain normal trade flows are needed only to deal with the
random imbalances in trade and payment flows. The size of these random
imbalances would increase less than proportionately to the size of trade flows.[5]

The second reason why it would be expected that the need for reserves
would be less than proportionate to the increase in trade would be the
innovations in the financial sector over the last four decades. It would be
reasonable to expect that improvements in information technologies would allow
central banks to gain greater knowledge and control over the flow of finances,
so that they could support a much greater volume of transactions with the same
amount of reserves. This has been the experience in the domestic banking systems
of all the industrialized nations. For example, in the United States, the ratio
of the reserves of the banking system to GDP fell from 1.7 percent in 1965 to
0.4 percent in 2000.[6] It is reasonable to expect
that comparable developments would allow central banks to similarly economize on
the use of reserves, and therefore offset the impact of a rising ratio of trade
to GDP.

Even if the rise in reserve holdings could be fully explained by the
increase in trade relative to GDP, it would still be important to note this
development. If increased reserve holdings of the size actually observed are
attributable primarily to the growth of trade, then a major cost of increased
trade has been overlooked. Few, if any, of the major trade models have factored
in the cost to developing nations of increased reserve holdings (e.g. Francois
et al 1996; Stoeckel et al 1990). This is an extremely serious omission in the
major models, if trade is the primary explanation of the rise in the ratio of
reserves to GDP. A model that accurately measured the cost of the necessary
increase in reserve holdings may find that the predicted gains from greater
trade are significantly reduced, and possibly eliminated altogether.

The other explanation for a rise in the ratio of reserve holdings to GDP
is that the world financial system has become more unstable over the last four
decades. A nation's willingness to incur the costs associated with increased
reserve holdings, for reasons other than maintaining stable trade flows, should
depend on the perceived probability and severity of a currency crisis. If
currency crises become more frequent, or the economic disruption they cause
becomes more severe, then it would be expected that central banks would raise
their reserve holdings. In this sense, the ratio of reserve holdings to GDP can
be seen as a simple (reverse) measure of the stability of the international
financial system.[7]

If the international financial system gains stability through time, as a
result of better management, improved technology in the financial sector, and
advances in economic knowledge, it would be expected that the ratio of reserves
to GDP would decline through time, holding everything else constant. The
increase in the ratio of trade to GDP is one factor that would have worked in
the opposite direction over the last four decades, as noted above. It is also
plausible that increased political instability could lead to a need for greater
reserve holdings. However, it would be difficult to argue that the last decade,
including the present period, is a time of greater political instability than
the sixties. That decade was marked by the Cold War between the United States
and Russia, and hot wars in East Asia, South Asia, and the Middle East, along
with serious guerilla struggles in Latin America and Sub-Saharan Africa. In
conclusion, the increase in reserve holdings over the last four decades must be
attributed either to the growth of trade or increasing financial instability.

The Path and Cost of Reserve Holdings

The ratio of reserve holdings to
GDP has risen substantially for developing nations in every region of the world
over the last four decades. Table 1 shows the average ratio of gross reserve
holdings to GDP for developing nations in each major region of world for the
four decades from the sixties to the nineties. The three years from 1997-1999
have been included separately to determine if the East Asian financial crisis
may have further raised reserve holdings.

The sharpest increases in reserve holdings relative to GDP came between
the sixties and seventies, with every region experiencing a significant increase
in this ratio. This rise coincides with the breakdown of the system of fixed
exchange rates in 1973. If the collapse of the Bretton Woods system was
responsible for most of the need for increased reserve holdings in the
seventies, it was a very costly event for developing nations. The average ratio
of reserve holdings to GDP nearly doubled in Latin America over this period,
rising from 5.0 to 9.1 percent. It increased by 4.0 percentage points in East
Asia, and by approximately 2.0 percentage points in both South Asia and
Sub-Saharan Africa.

In the eighties, the ratio of reserve holdings to GDP fell slightly in
both Latin America and Sub-Saharan Africa. There was a large jump of 10.2
percentage points in the Middle East and North Africa, perhaps reflecting the
new oil wealth in the region. In South Asia the ratio rose by 1.8 percentage
points, slightly less than in the seventies. In East Asia, the ratio of reserves
to GDP rose by 3.2 percentage points.

There was another large jump in the ratio of reserves to GDP in the
nineties in Sub-Saharan Africa (4.3 percentage points), East Asia (3.1
percentage points), and Latin America (1.9 percentage points). The ratio rose by
0.3 percentage points in South Asia, while it fell in the Middle East and North
Africa. In Latin America it was 1.4 percentage points higher.

The late nineties saw a further
increase in this ratio relative to the decade long average (which includes the
last three years). In both East Asia and Sub-Saharan Africa the ratio was
approximately 2 percentage points higher in the last three years than the decade
long average. In South Asia there was little change in the ratio reserve
holdings to GDP, while it fell by 1.3 percentage points in the Middle East.

The rise in reserve holdings over
the last four decades carries a large implicit cost to developing nations. As
noted before, the cost of holding reserves is the marginal product of physical
or human capital in the country minus the real return on reserve holdings. By
treating this difference as 10 percentage points at the low end, and 20
percentage points at the high end, it is possible to estimate ranges of the cost
to developing nations of the increase in the ratio of reserve holdings to GDP
over the last four decades.

Table 2 shows that the cost of the
increase in reserve holdings over the last three decades has been substantial.
The first two columns show the annual losses, expressed as a share of GDP, that
result from having to hold additional money as reserves rather than invest it in
physical or human capital. The calculations are measured against an alternative
scenario in which the ratio of reserves to GDP remained at its average level for
the sixties. South Asia is the region least affected by the increase in reserve
holdings, but even here the implied loss is important. In the low cost case,
even for South Asia, the opportunity cost is equal to 0.4 percent of GDP each
year. In the United States, a loss of this magnitude would currently be over $40
billion a year. Also, it is worth emphasizing that this low cost estimate is a
lower bound based on the assumption that the return to capital in developing
countries is barely higher than in the US.So the real costs are certainly higher than this low cost estimate.

East Asia and the Middle East are
the regions that have incurred the largest costs as a result of the increase in
reserves. In the low cost scenario, the increase in the ratio of reserves to GDP
has cost East Asian nations 1.0 percent of annual GDP, and nations in the Middle
East 1.1 percent of GDP. In the high cost scenario the lost output due to
increased reserve holdings has been 2.1 percent of annual GDP in both cases. In
the United States, this would be equivalent to a loss of more than $200 billion
in annual output.

The calculation of cumulative lost output in the second set of
columns is a projection that sums over a decade the projected losses from
maintaining the nineties ratio of reserves to GDP. The loss is expressed as a
percentage of the first year's GDP. (This calculation assumes, conservatively,
that the real growth rate averages 3.0 percent annually.) The least affected
region, Sub-Saharan Africa, would still incur a decade long cost from its
increased reserve holdings equal to 4.6 percent of GDP, even in the low cost
scenario. In the United States, a loss of this magnitude would exceed $460
billion. The cumulative loss from the increased reserve holdings in East Asia
and the Middle East would be close to 12 percent of GDP in the low cost case
scenario and around 24 percent of GDP in the high cost scenario. In the case of
the United States, this would translate into a loss of between $1.2 and $2.4
trillion.

While these losses are substantial
by almost any criterion, the situation may have permanently worsened as a result
of the East Asian financial crisis. In the wake of this crisis, developing
nations throughout the world have sought to increase their holdings of reserves
as a way to protect themselves from financial instability. As a result, in most
regions of the world the ratio of reserve holdings to GDP increased
substantially in the last three years of the decade, compared with the decade
long average. Table 3 shows the cost to developing nations of maintaining the
reserve to GDP ratios of the late nineties, compared to the ratios of the
sixties.

As can be seen, the cost of
reserve holdings increased substantially in East Asia, Latin America, and
Sub-Saharan Africa. It was little changed in South Asia and decreased slightly
in the Middle East. The higher ratio of reserves to GDP implies a substantial
new burden for many developing nations. The late nineties ratio implies an
annual loss of between 1.2 percent and 2.4 percent of GDP annually, for the East
Asian nations, the region most directly affected by the financial crisis. In
Sub-Saharan Africa and Latin America the cost of the late nineties reserve
holdings is between 0.8 percent and 1.6 percent of GDP, when compared to the
ratios maintained in the sixties. The cumulative losses over a decade would
exceed 25 percent of GDP in the case of the high cost scenario for East Asian
countries.

At this point it is too early to
know whether the late nineties build-up of reserves by developing nations was a
temporary response to financial instability which will be reversed in the near
future, or whether it marks a permanent increase in the quantity of reserves
that nations consider necessary to protect their currencies. However, it is
clear that developing nations have already incurred a substantial cost as a
result of this rise in their reserve holdings.

To be certain that this increase
in reserve holdings is not driven by the behavior of small countries, regional
averages were constructed using GDP weights. This data appears in table 4.

Table 4 – Reserve Holdings As a Share of GDP, by Decade and Region
(weighted by GDP)

Region

1960's

1970's

1980's

1990's

'97-99

East Asia and Pacific

8.9%

6.8%

12.4%

20.4%

24.2%

South Asia

1.9%

3.8%

4.3%

5.7%

6.9%

Latin America and Caribbean

3.0%

6.3%

6.2%

7.9%

8.4%

Sub-Saharan Africa

5.5%

6.8%

4.8%

6.9%

9.5%

Middle East and North Africa

8.2%

20.0%

13.8%

16.1%

17.0%

Source:
World Bank 2001 and authors' calculations.

This table shows somewhat
different patterns to the rise in reserve holdings, with the increase in reserve
ratios being somewhat larger for the East Asia and South Asia, and slightly
smaller in the case of the Middle East. The data show that Latin America and
Sub-Saharan Africa have a considerably smaller increase in reserve holding when
GDP weights are used, suggesting that smaller countries have been the ones most
affected by the need to increase reserve holdings.[11]
But the weighted data does not change the general pattern. Reserve holdings
increased substantially in all regions from the sixties to the nineties, with a
further increase in the last three years of the decade.

Table 5 shows estimates of the cost of the increase in reserve holdings,
using the weighted averages of the ratio of reserves to GDP for the late
nineties.

As can be seen, the cost of the
increase in reserve holdings is still substantial for all regions, with the
opportunity cost for nations in the East Asian region exceeding 3.0 percent of
annual GDP in the high cost scenario. The costs are lower for nations in Latin
America and Sub-Saharan Africa when the weighted averages are used, but even in
the low cost case for Sub-Saharan Africa, the increase in reserve holdings over
the last four decades still constitutes a loss equal to 0.4 percent of annual
GDP.

Conclusion

The rise in the ratio of reserve holdings to GDP over the last four
decades is a striking but little noted phenomenon. By the late nineties, the
vast majority of developing nations held reserves that were far larger, measured
as a share of GDP, than they had in sixties. This increase has occurred in all
regions of the developing world, although the timing has varied by region. In
East Asia, the region with the biggest rise in reserve holdings, the ratio of
reserves to GDP increased by more than 12 percentage points over the last four
decades. In both Latin America and Sub-Saharan Africa the increase was close to
8 percentage points.

This increase in reserves
represents an enormous cost to developing nations. To accumulate reserves,
nations have to forego domestic investment in either physical or human capital.
The potential return on this investment is the opportunity cost of holding
reserves. The gap between the return on investment in developing countries and
the real return on the reserves is between 10 and 20 percentage points. This
implies that the increase in the ratio of reserve holdings to GDP over the last
four decades has imposed costs that exceed 1.0 percent of GDP, and possibly 2
percent of GDP, for many developing countries. The equivalent cost in the United
States would be $100-$200 billion a year.

The main explanations for the
increase in the ratio of reserve holdings to GDP are increased trade and
increasing financial instability. If increased trade is primarily responsible
for the increase in reserve holdings, then most trade models have excluded a
very important cost. Estimates of the benefits from expanded trade would be
substantially reduced if the cost of the implied increase in reserve holdings
was included.

Alternatively, if increasing
financial instability is the main explanation of the rise in the ratio of
reserves to GDP, then this indicates a serious failing of international
financial institutions. The improvements in information technology and
innovations in economic and financial theory should have led to growing
stability in the world financial system. If the financial system has instead
become less stable, this is prima facie evidence of serious mismanagement.

Appendix

The data on reserve holdings is taken from the World
Bank's World Development Indicators 2001, tables for "Gross
international reserves (includes gold, current US$)" and "GDP at
market prices (current US$)." Data for Taiwan came from Central Bank of
China (2000).

References

Ben-Bassat, A. and D. Gottlieb, 1992. "On the Effect
of Opportunity Cost on International Reserve Holdings." The Review of Economics and Statistics, V. 74, May, 329-332.

Francois, J., B. McDonald, and H. Nordstrom, 1996.
"The Uruguay Round: A Numerically Based Qualitative Assessment." in The
Uruguay Round and the Developing Countries, W. Martin and A. Winters, eds.,
Cambridge, U.K.: The World Bank and Cambridge University Press.

Neely, C. 2000. "Are Changes in Foreign Exchange
Reserves Well Correlated with Official Intervention? Economic Review of the Federal Reserve Bank of St. Louis,
September/October, 17-30.

Shinkai, Y. 1979. "Demand for International Reserves
in Less Developed Countries: A Comment." The
Review of Economics and Statistics, V. 61. November, 614-615.

Stoeckel, A, D. Pearce, and G. Banks, 1990. Western
Trade Blocks: Game, Set or Match for Asia-Pacific and the World Bank.
Canberra, Australia: Centre for International Economics.

World Bank, 2001, World
Development Indicators 2001, Washington, D.C., USA.

[1] There has been some
confusion in the literature on the appropriate opportunity cost to assign to
reserve holdings. For example, Frenkel (1981), Shinkai (1979), and Iyoha
(1976) treat the opportunity cost as the interest rate on government debt.
As is explained in the text, this sets up the wrong counterfactual. If the
assets were not held as reserves, they would be available to nations to fund
domestic investment in physical capital. The return on such investment is
therefore the correct measure of the opportunity cost of holding reserves.

where
DR is
the change in reserves, X-M is the surplus of exports over imports, FYd
- DYfisthe
surplus of receipts of factor incomes (e.g. interest and dividends earned on
the foreign assets of the nation's citizens or the labor income earned by
its residents when they worked abroad), FId - DIf is
the surplus of foreign investment within the nation (both direct and
financial) over investment that domestic firms and citizens undertake
abroad, and FAd - DAf is
the surplus of foreign aid given to the nation over the aid that the nation
may give to other nations.

[3] The before-tax rate of
return would be the appropriate measure for calculating the opportunity cost
of capital, since tax revenues are also part of the return to the country.

[5] If the imbalances are
randomly distributed, then their size should increase in proportion to the
square root of the increase in trade. So, if trade quadruples, then the
expected size of imbalances – and the need for reserves – should double.

[7] It is worth noting that a
measure of stability that only examined the volatility of movements in
currency prices, without examining changes in reserve holdings, could
present misleading findings. If there were two time periods in which the
volatility of movements in currency prices were comparable, but the ratio of
reserve holdings to GDP had risen substantially, then it would imply that
nations had incurred a substantial cost in the second period to keep the
level of volatility constant.

[8] The data for South Asia
excludes Bhutan and Maldives. Both were outliers with ratios of reserve
holdings to GDP which are far above the average for the region.